Building an investment portfolio is like grocery shopping. As you peruse the aisles, you might consider grabbing items from each food group. Doing so would probably guarantee you’d have all the nutrients, flavors, and textures you could possibly crave. If nutrition meant checking off every item at the grocery store from a list, consumption habits would be the same for everyone. However, every body and lifestyle requires a unique diet. Therefore, excluding some items and buying only specific subsets of foods offered by the store may be better for you.

Building an investment portfolio can be just as intimidating as grocery shopping. The parallels between the process of constructing your investment portfolio and choosing what to put in your cart at the store based on your unique needs and preferences can help you evaluate your asset allocation strategy. 

Adding Items to Your Cart

The aisles you visit while grocery shopping are probably different than those visited by other people around you. Whether you are a vegan or shopping for a growing child, the items you purchase will need to fulfill your specific needs. Maybe you are extra careful with your selections as you might have gluten sensitivity, or you might avoid complete sections filled with candy as a person with diabetes. In summary, your body’s desire for certain foods leads you to shop for only some subsets of foods, not all. When the time to check out arrives, each grocery cart looks different. Building an investment portfolio is similar.

An Endless Amount of Cereal Options and Stock Options

Investing in publicly traded stocks and bonds is relatively easy and cheap when you are using a global fund or three. You’d have maximum diversification at fairly low costs, which is generally reasonable. 

Similarly, having Cinnamon Toast Crunch, Frosted Flakes, and Pops in your cart leads to diversification in your diet. But, imagine you become intolerant to these brands, then you would have to remove these from your diet. That might mean focusing on cereals that add nutritional value rather than filling your cart with all the different cereal boxes. 

Similarly, with investments, you might have some needs and preferences that would benefit from eliminating some of these global investments in exchange for other portfolio characteristics. Let’s talk about some of those trade-offs.

Prioritizing the Grocery Aisles 

The first and probably most important one would be your ratio of stocks to bonds. The global portfolio is bond heavy. Buying the global portfolio would be around 60% bonds. This might not be the best idea for all. For example, this situation would probably be unideal for a 25-year-old investing for retirement. If that were you, you’d probably prefer little if any bonds in your portfolio. Many who rely heavily on bonds are looking for the safety they provide. Retirement is far off in the future and youth is the time to take smart risks.

3 Aisles You Should Not Exclude

What if you wanted higher expected returns for your stocks? Well, some things we know about stocks can help us increase expected returns in your portfolio. Risk is always related to return. Sometimes companies that are riskier individually aren’t too risky when included in a diversified portfolio. 

Small companies have higher expected returns than big ones. Why? Risk. Small companies fail more often, so investors require more return to invest in them.

Value (or struggling) companies have higher expected returns than growth (or great) companies. For example, companies like Kmart have higher expected returns than Amazon because risk is related to return, and Kmart is riskier (they are flirting with bankruptcy).

One more screen we might use for stocks is profitability. It turns out that the most profitable firms today tend to generate the highest expected returns in the future.

Here’s an example of how this might help you. If you invested in the stock market in 1973, your dollar grew to $80 by 2011. Your dollar grew to $572 over the same period using value and profitability as preferences. So, in this case, less diversification is a very powerful tool for tailoring your unique investment requirements to your financial goals.

A Great Amount of Protein and Bond Options

Now, for the bond side of your investment portfolio. Bonds are usually not a great source of risk-adjusted returns. The expected return goes up along bond maturity growth. However, risk increases much more with the bond’s maturity growth than returns. Bonds become very price volatile as they respond to changes in interest rates. Investing only in short-term bonds (5 years or less), and buying longer-term bonds when the interest rate they offer is significantly higher (steep yield curve), can be a good way to make sure you buy just the right amount of protein for the week.

Bonds also pay investors for taking the underlying risk of the company. Risky bonds (junk bonds) don’t always offer a return commensurate with their risk. In this case, we prefer to invest in quality bonds. If you were to buy lower quality bonds, it should be when significantly more return is offered (this is called high credit spreads).

Generally, we see bonds as a source of safety, not a great source of real returns. Short-term and high quality are the two main characteristics required for bonds to stabilize the portfolio.

Ideally, I have a stock portfolio that’s smaller, cheaper, and more profitable than the market. I have a shorter-term bond portfolio and higher quality than the market. I also have a mix of stocks to bonds that are right for my life stage.

Don’t Forget to Look at the Prices of the Items You Check Out

What about values? Should you avoid or reduce investments in companies whose ethical behavior does not align with your values? Ask yourself: Are the companies I’m investing in aligned with me on the environment, social justice, politics, religion, healthcare, and other views? If not, you may wish to eliminate or reduce investment in firms that don’t match your values.

Only Buy What Adds Value

If you’ve followed these tips, you likely have a smaller, cheaper, more profitable stock portfolio to provide higher expected returns. In addition, you have a shorter-term, higher-quality bond portfolio to stabilize your account during challenging market conditions. Plus, you’re investing in companies whose values align with your own.

By being a choosy investor (shopper), you might improve your investment experience considerably by giving up some diversification in exchange for portfolio characteristics more aligned with your needs and preferences, just like you do at the grocery store.

As you can see, this is not a simple process. However, working with a fee-only Certified Financial Planner professional can help navigate the complexities we’ve discussed here, and the design/maintenance and portfolio suitable to your specific needs.